Assessing risk in the Paarl/Berg River region by means of various portfolio diversification models

Abstract:

The need to take account of risk in agriculture must be part of every decision taken in agriculture. Yet risk is nothing to be too afraid of. Risk is a choice rather than a fate. The actions we dare to take, which depend on how free we are to make choices, are what the theory of risk is all about. The task is rather to manage risk effectively, within the capacity of the farmer, business or group in order to withstand adverse outcomes. Some methods of managing risks are feasible for all types of farms. Others are only feasible for certain sizes and types of farms. Therefore, farmers in general need a systematic technique that will enable them to choose an efficient investment strategy from among all feasible strategies. Specifically, given n risky assets (such as the different enterprises in the Paarl/Berg River region), it is essential to seek a diversification strategy which yields a portfolio lying on the efficient frontier. The research question was whether different diversification models (Markowitz diversification model, Single Index Model and the Capital Asset Pricing Model) that are normally applied in capital markets for the construction of optimal diversified portfolios consisting out of different shares, are also applicable on risky portfolios in agriculture comprising different enterprises in the Paarl/Berg River region. The efficient frontier can be seen as the graphical representation of a set of portfolios that maximize expected return for each level of portfolios risk. The Microsoft Excel portfolio optimizer (SOLVER) programme was used to illustrate the investment proportions, expected returns, and standard deviations of the portfolios of the efficient frontier. The Single Index model (SIM) can be used as alternative to Markiwitz diversification model. It drastically reduces the number of parameters needed to be estimated and yields the efficient set relatively easily without the technical difficulties characterizing the full rank solution. However, if the SIM assumptions are in contradiction to the actual data, the simplification of the calculations is achieved at the cost of getting imprecise results. The simplicity of SIM calculations was attained at a cost of constructing a sub-optimal portfolio, which does not lie on the corresponding efficient frontier. The Capital Asset Pricing Model (CAPM) reveals that there is a great deal of systematic risk in relation to the portfolio enclosed in this study. By using the CAPM it is possible to determine which part of the risk the producer can control (non-systematic risk) and which part the producer has no control over (systematic risk). The proportions of systematic risk that can be diversified away are small, relative to the total risk of the Farm Sector Portfolio. The success of these models depends on the efficiency of the market, as well as large, up-to-date and reliable data source. Many younger cultivars could not be included in this study, due to the limited availability of data. In the next few years as data become available, it will be possible to construct efficient frontiers out of a wider range of enterprises. Different enterprises and cultivars will increase the number of alternative uses for natural resources in the Paarl/Berg River region through diversification. This will result in more choices for the farmer, and more flexibility in the decision-making process. Without reliable data, the result will be "garbage in, garbage out."